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States have long been considered the best group of issuers in the municipal bond market, thanks to modest debt levels and ample taxing power. That's still the case, though many states, including Illinois, Connecticut, New Jersey and Hawaii, are bedeviled by large unfunded pension liabilities stemming from weak investment returns and inadequate state contributions to the plans. Adding to the strain are huge and growing unfunded liabilities for post-retirement health care for state employees.

That strain was brought into sharper focus recently with
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disclosure that it had terminated $8 billion of municipal derivatives contracts. Those contracts were effectively bullish bets on state finances. Berkshire CEO Warren Buffett is bullish no more. The company's $30 billion bond portfolio is light in munis, and Buffett is warning about rising municipal bankruptcies and of the risks of insuring tax-exempt debt. "The stigma probably has been reduced when you get very sizable cities like Stockton and San Bernardino to do it," Buffett told Bloomberg television last month, referring to the bankruptcy of the two California cities. The fiscal pain -- and credit risk -- is more pronounced at the local than state level.

For municipal bond investors, it all boils down to this: The risk of investing in the debt of some of the country's least financially sound states, compared with the most sound, is not always reflected in the price of their bonds.

By the measure we use, which looks at the combined debt and unfunded pension liabilities relative to GDP in each of the 50 states, South Dakota comes out on top. The state has a strong agricultural economy and a low jobless rate of 4.4%, about half the national average. Debt and unfunded pensions add up to just 1% of GDP. Connecticut, which ranks at the bottom of the list, has a combined score of 17%. Yet the bonds in both states are priced alike, at 28 basis points above the 10-year AAA-rated benchmark, which yields around 1.8%. A basis point is one-hundredth of a percentage point.

Granted, the risk of Connecticut -- or any state, for that matter -- defaulting on its debt is small, but investors are not being rewarded for taking any risk at all.

The ratings agencies, which take a state's economic strength, wealth and taxing power into account, show somewhat different results. Moody's Investors Service sets the average credit rating for all 47 states at a strong Aa2; 15 states have triple-A ratings. It doesn't rate South Dakota, Nebraska and Wyoming because they have virtually no debt.

The two states with the lowest credit ratings, Illinois and California, are still at single-A, comfortably within the investment-grade category, though Illinois muni debt is priced dramatically higher than the other 49 states, at 157 basis points above the AAA benchmark.

Puerto Rico is off the charts in every metric.

High-quality 30-year muni bonds carry yields in the 3% to 3.5% range. And here, too, with little differentiation being made among the states, investors can benefit by purchasing debt of the better-run states at similar yields to some of the worst. Many individuals from high-tax states admittedly only buy debt from their own states because out-of-state debt is subject to their state's income taxes. Yet many pros advise some state diversity in holdings, especially if munis make up a large portion of an individual's portfolio.

WHICH STATES LOOK BEST? In addition to South Dakota, Iowa, Tennessee and North Carolina are at the top of the list. (Our ranking is based on analysis from Eaton Vance, a leading manager of municipal funds, that measures state debt and unfunded pension liabilities.) The bottom-ranked states are Connecticut, Illinois, Hawaii and Kentucky. Eaton Vance supplied data on 43 states based on publicly available information; that was supplemented by Barron's analysis of the other seven states based on a similar methodology.

"The majority of states are in good shape, but there are some that are more challenged with pension pressures, weak economies, poor finances and limited ability to raise taxes," says Jim Evans, a municipal portfolio manager at Eaton Vance. "Pensions are an important credit factor because pension benefits are almost always constitutionally protected at the state level."

The fiscal backdrop is better than it was three years ago. State tax revenues rose for the ninth straight quarter in the first three months of 2012, increasing 4.7% from the first quarter of 2011, according to the Nelson A. Rockefeller Institute of Government at the State University of New York in Albany. Projected state fiscal gaps nationwide in the current fiscal year, ending in June 2013, are the lowest since before the financial crisis in 2008. Unlike the federal government, states have to balance their budgets each year, although some have resorted to fiscal gimmicks like asset sales and securitization of future revenues from cigarette companies to eliminate red ink.

"We have been more optimistic than the doomsday folks," says Tom Kozlik, municipal bond analyst at Janney Capital Markets. "The willingness of states to service their debts remains strong." In 2010, the muni market was rattled when analyst Meredith Whitney predicted widespread defaults; that never happened.

States had $510 billion of tax-supported debt outstanding at the end of 2011, according to Moody's. That is comprised primarily of general-obligation bonds, which are backed by the full faith and credit of the issuing state.State debt is a relatively small part of the $3.7 trillion muni market.

THE BIGGER PROBLEM IS PENSIONS. Eaton Vance puts the total unfunded liability of the states at $401 billion, for the fiscal year ended in June 2010, the last year for which complete state data are available. The pension gap is based on states' assumed investment returns, which average about 8%. But Eaton Vance, Buffett and many others argue that the assumptions are aggressive in light of ultra-low rates, a mediocre economy and a lackluster stock market over the past decade.

In a Moody's analysis of state and local pension obligations, the ratings agency found a $766 billion liability based on 2010 data. That's a best-case scenario. Assuming a 5.5% return, which the ratings agency has proposed using to discount pension liabilities, the number balloons to $2.2 trillion, split about equally between state and local governments.

A report from the Pew Center for the States, meanwhile, puts the pension gap at $757 billion nationwide. Its analysis shows another $627 billion of unfunded health-care liabilities. Pensions were almost 80% funded on average in 2010 based on admittedly high investment-return assumptions, but only 5% of post-retirement health-care obligations had been funded by states. California, New Jersey, New York and many other states had little or no money set aside for future health-care needs and were meeting those expenses out of their annual budgets.

INDIVIDUAL STATE PENSION BURDENS rise considerably in a low investment-return scenario. Connecticut's combined debt and pension burden rises to 24% of its GDP from the 17% shown on the table, while Illinois' total liability also grows to 24% from 16%, according to Eaton Vance.

Connecticut's fiscal woes aren't reflected in the bond market, where its 10-year debt yields only about one-quarter point above the triple-A average, and its debt ratings still are a solid double-A from both Moody's and Standard & Poor's. That said, Moody's downgraded Connecticut's general-obligation debt in January, to Aa3 from Aa2, citing "high combined fixed costs for debt service and post employment benefits relative to the state budget" and pension funding ratios that are "among the lowest in the country" at around 50%.

One muni manager says outdated investor perceptions aid Connecticut, including its former status as a top-rated state -- an idea that the whole state is one big version of Fairfield County, the wealthy region that includes tony towns like Greenwich, Darien, and Westport. Connecticut's major cities, including Bridgeport and New Haven, are depressed and a drain on the state's coffers. Once known as a low-tax alternative to neighboring New York, Connecticut now has the third highest state and local tax burden in the country at 12% of per capita income, behind New York and New Jersey, according to the Tax Foundation.

Illinois, too, is a mess, with a pension plan that is less than 50% funded and a deficit of over $75 billion in 2010. Union opposition recently helped kill a recent legislative effort to alleviate state budget pressure by reducing annual cost-of-living adjustments on pensions or requiring higher health-insurance payments by state employees.

The rating agencies don't view pension liabilities as being as onerous as debt because states can implement change to benefit plans to reduce their obligations. Recognizing the growing danger of underfunded plans, some 43 states have enacted pension reforms since 2010. Yet these trumpeted measures sometimes haven't done much to reduce underfunding because the actions also were accompanied by meager annual state contributions to pension plans.

New Jersey governor Chris Christie last year got concessions from state and local workers, including teachers, on pensions, but that came after the state made little or no contributions to its pension plans from fiscal 2009 through 2011. New Jersey doesn't expect to make its full actuarial recommended contribution until 2018. Fitch Ratings noted that the state's pension plan, which was 65% funded in 2010, is projected to fall to 53% by 2015 even with reforms. Moody's warned in downgrading the state's debt rating last year to Aa3 from Aa2 that fixed cost for debt service, pension and health care could eat up 30% of the state budget by 2019, crowding out other expenditures.

By comparison, most of the top states on our list have well-funded pensions. Tennessee has kept debt low and has made full contributions to its pension plan since 1972. As a result, its plan is 90% funded. Fiscally conservative Texas has better-than average debt and pension funding levels plus one of the largest rainy-day reserve funds of any state. It also has a healthy economy.

New York has a reputation for excessive government spending and onerous taxation. That's borne out by the state's enormous Medicaid tab, but New York's pension funding level of 94% is one of the best in the country, putting it in much better shape than neighboring New Jersey or Connecticut. Wisconsin is the only state that was 100% funded on its pensions in 2010. It used to have a lot of company because the average state was fully funded in 2000. That was right before the tech bubble burst, ushering in a low-return decade for the U.S. stock market and a rocky financial environment that prompted many states to skimp on pension contributions.

The situation didn't get much better in fiscal 2011 even though investment returns were strong; a study by the Center for Retirement Research of Boston College found that 126 state and local plans were only 75% funded as of June 2011.

There is no quick fix. More realistic approaches to retirement-related benefits can help stem the growth of the states' liabilities, as can tighter budget controls. But the one variable that cannot be controlled is investment returns, and the fiscal year that ended this past June was no doubt another tough one. For example, the giant California Public Employees Retirement System, the largest state plan, with $233 billion in assets, had an investment return of 1%, far below its assumed return of 7.5%.

There is no immediate danger, either. While the pension problems should not be minimized, the vast majority of states are in a strong financial position, and their debt offers investors considerable safety -- even if yields are paltry in today's low-rate world.

Puerto Rico Munis Are No Vacation

Among major tax-exempt bond issuers, the Commonwealth of Puerto Rico carries the most risk by far, but the U.S. territory's financial and economic woes don't appear to be reflected in its bond yields.

Puerto Rico carries a large net debt load of $51.9 billion, higher than every state except New York and California. It also has a big unfunded pension liability of $33 billion. The territory's economy is only starting to recover after a long downturn that started in 2006. Unemployment is high, at 13.7%, and incomes are low.

The territory's ratios of debt to personal income and GDP are off the charts relative to the states with a debt/GDP ratio of 53%, against a 3% average for the states. Combine debt with unfunded pension liabilities and the ratio to GDP approaches 90%. Puerto Rico's governor since 2009, Luis Fortuna, gets good marks for his efforts to revitalize the island's economy, including cuts in bloated government employment and some tax cuts, but he faces a tall order in restoring long-term economic health.

IN A JUNE REPORT, the Federal Reserve Bank of New York wrote "the competitiveness of the economy has been deteriorating" and that "scant progress has been made in addressing the island's long-standing high unemployment." Some tax breaks to U.S. manufacturers expired in 2006, about the time the island's economy began a long slide. One impediment to business is high electric costs, which are nearly triple the U.S. average.

Debtor's Island

Puerto Rico has significant debt, a large pension liability and a weak economy. Not a good combination for bondholders.

Puerto Rico bonds still have investment-grade bond ratings from Moody's, S&P and Fitch in the triple-B range, which is one notch above junk status. Moody's has warned it may downgrade Puerto Rico's debt, which would raise the territory's borrowing costs and further stretch its balance sheet.

There are multiple debt issuers in Puerto Rico, most of whose finances are intertwined with the government. They include the Public Buildings Authority and Government Development Bank. The Sales Tax Financing Corp., or Cofina, is viewed as the best credit because its $15 billion debt is backed by a dedicated revenue source from sales and use taxes. It has double-A ratings.

Janney has called the government's financial disclosure "opaque" and that was underscored earlier this year when Moody's did an extensive study of the island's finances and found $7 billion more debt than it previously had counted. That's not an encouraging development.

PUERTO RICAN BONDS are widely held in municipal bond funds, including many single-state funds, because interest is exempt from income taxes in all 50 states. Many fund managers looking to boost yields in a low-rate environment have gravitated to Puerto Rico debt. The $106 million
Oppenheimer Rochester Maryland
fund (ticker: ORMDX) has 40.9% of its assets in various Puerto Rico issuers, and the
Oppenheimer Rochester Virginia
fund (ORVAX) has a 36.5% weighting. Puerto Rico debt is a far cry from Maryland and Virginia general-obligation bonds, which are triple-A rated.

While Oppenheimer fund prospectuses permit such Puerto Rico investments and returns on those funds have been strong, it's debatable whether any single-state fund should have such a large out-of-state exposure, especially to lower-rated bonds.